July 23, 2017
Thomas Heath used his column to give readers some incredibly bad investment advice. The piece titled, “a first lesson on the stock market: don’t run from a good sale,” told readers that the recent dip in the market makes this a good time to buy stock. This makes no sense.
Whether or not it is a good time to buy stocks depends on the price of stock relative to the fundamentals of the market. This means current price-to-earnings ratios and the prospect for future earnings growth. Current price-to-earnings ratios, at well over 20 to 1 by most measures, are high by historical standards. Most economists are not projecting especially good profit growth in the years ahead, but a big tax cut may allow shareholders to keep a larger portion of their gains, which would make stock more valuable.
But the point is not whether it is a good or bad time to buy stock, the point is the fact that stock prices have fallen really doesn’t tell you anything. In March of 2000, the Nasdaq peaked at just over 5000. It fell back from this peak, so that a month or so out it was at 4,000. By Heath’s investment advice, everyone should have taken advantage of this big sale. After all, prices were down 20 percent from their peak.
If you followed the Heath investment strategy you would have lost more than two thirds of your money as the Nasdaq eventually bottomed out at just over 1200 in the fall of 2002. While the Nasdaq did eventually come back and is now near 6,400, this would not have provided much of a return if you bought in at 4,000. Adjusted for inflation, this would give a real return of just over 11.0 percent over a seventeen year period. Dividends would add to this modestly, but since most Nasdaq stocks pay little or no dividend, the return would still be extraordinarily low over this period.
The moral of this story is that if the price of an over-valued asset falls, it is less over-valued, but a drop in price does not mean that the asset is under-valued. An investment advice column should show a little clearer thinking on this issue.
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